Alan Greenspan calls it a 'conundrum', and at least some econobloggers are worried about long bond yields - and the yield spread - being so low despite higher Fed rates and a relatively buoyant US economy.
James Hamilton is worried we could see an inverted yield curve if the Fed keeps hiking rates. Inverted curves (where the long bond yield is less than the cash or money market rate) preceded the last two recessions. Could this happen again?
In the three more recent episodes (1984, 1989, and 1994), the Fed pulled back before a recession actually began. In each of these, that meant stopping after about a 300 basis point hike. If the Fed did the same thing this time, they'd maybe call it quits when the funds rate hits 4%. However ..if we see longer term yields drop back down, that could put us in a position of an inverted yield curve, which historically has been a fairly ominous development.
Dave Altig at Macroblog is less concerned about excessive Fed tightening. He examines the yield spread and asks: How far is too far?
That is, what does history tell us about the association of future GDP growth and a particular level of the difference between long-term and short-term interest rates?
After several charts and commentary, Altig reaches a fairly benign conclusion:
All of this is to say that it is not clear, to me anyway, that fears of too much liquidity creation should be any greater today than they were back then [1991-95]. Nor is it obvious that we are any closer to a large mistake in excessive tightening.
(Hat tip to Mark Thoma). But Hamilton is not convinced; he returned to the topic of The puzzle of long-term yields yesterday. Drawing inspiration from The Hound of the Baskervilles, he discusses "a few canines that don't seem to be yipping around the decline in long-term bond yields":
There thus seem to be plenty of attractive explanations for the decline in long-term Treasury yields over the last four months. One might be able to attribute up to half of the decline to foreign purchases, or try to pin the whole thing on decreasing inflation expectations.
So why aren't Greenspan and others convinced? The problem is that when you look at the behavior of each of the above graphs for the past year as a whole ..rather than just since March, everything goes in the wrong direction.
So if, on a year-to-year basis, neither the inflation terrier nor the foreign-purchasing poodle are yapping, what are we left with? It seems to me you then have to attribute much of the year-to-year decline in long-term yields to a decline in the term premium itself. And as my research with Dong Heon Kim has shown, this is exactly the sort of thing that can often be an early signal of an economic downturn.
Worried yet? Then read the piece by Katie Benner of CNN, Old conundrum, new twist. She provides reasons why the yield curve points to a weaker Federal Reserve, not a downturn. (Hat tip, again, to the ever helpful Mark Thoma).
Of course this issue is unresolved and has further to run. More posts as things develop...